Why some firms are bailed out and others ignored

Those sinking in the wake of the real estate plunge get different treatment. For the overall economy, it makes sense.

By
David R. Francis /
September 22, 2008

Home prices in the United States are down about 18 percent. Some predict the eventual price decline will reach 30 percent. Since the total value of houses was approximately $20 trillion, the loss in underlying value could reach $6 trillion if the gloomy forecasts prove correct.

That hints at the order of magnitude of the potential losses facing Washington with the latest plan for creation of some sort of federal authority to buy troubled mortgages and mortgage-backed securities. Such losses would far exceed the losses of the Resolution Trust Corp., created to clean up the savings-and-loan crisis of the 1980s.

The earlier emergency negotiations in New York hung in part on the issue of who takes the present losses. Is it Uncle Sam? Or should shareholders of troubled firms suffer the losses through bankruptcy – or perhaps sale of bad assets to a new rescue agency at sharp losses? These shareholders, by the way, include pension funds and mutual funds relevant to millions of people.

"The problem is that this financial crisis is spreading through nearly every kind of financial liability – and it is not going to stop," warns Mr. Wray.

Bear Stearns Cos. got a merger deal last March, a step then considered vital to Wall Street stability. Fannie Mae and Freddie Mac were taken over by the government earlier this month since they are so important to the nation's housing market. Lehman Brothers was allowed to fail last week. Its bankruptcy was not considered a threat to the entire financial system.

And last Tuesday, Washington seized control of American International Group Inc. through a bailout loan of up to $85 billion, giving it in effect a 79.9 percent equity stake in the giant insurance company. It was considered too big and financially important to be allowed to fail. AIG's business included the sale of credit-default swaps, complex financial contracts that allow buyers to insure investments tied to mortgages – the paper hit by declining home prices and shady dealings in many cases.

Moreover, AIG has a huge business in China, which owns some $1.8 trillion of US Treasuries, and is active in other nations in Asia. So an AIG bankruptcy would have been upsetting not only inside the US.

Actual losses in US housing depend partly on whether the US slips further into recession, as Wray expects. Consumers are already becoming more cautious as unemployment rises, their home and stock-market wealth declines, and credit becomes harder to obtain. Losses also hang on whether mortgage holders give homeowners more time or easier terms to manage their debts.

The crisis is widely expected to lead to tighter regulation of the financial markets. "We have to," says James Galbraith, an economist at the University of Texas, Austin. He charges that there has been a "systematic destruction" in the quality of regulation of the nation's financial system. "The center of the world's currency system has been run irresponsibly and fecklessly," he says.

Both presidential candidates are talking about reform of the financial system. Voters will be left to decide which of them is more credible in this area.

Though not spelling out specific details for tightening regulation, Mr. Galbraith holds that any new rules must stop "sharp practices and buccaneering."

Wray gets more specific. Banks should not be allowed to put liabilities in special-purpose accounts off their regular balance sheets, an amount he estimates at $10 trillion. "Regulators should know exactly what their liabilities are," he says. That includes some of the $18 trillion or so in credit-default swaps held by banks, out of a total of about $50 trillion. Wray adds that some insurance companies may not hold any reserves at all against such massive liabilities.

Further, he maintains that banks should not be allowed to leverage their investments to such extremes as 30 or 40 times their own capital. Under Basel Accord II, a 2004 agreement covering banks in much of the world, banks are supposed to limit their investments to about 12 times their own capital. But the investments were risk adjusted, and investments based on mortgages were considered safe. That assumption, of course, proved false, leading to the shaky position of some banks today.

Regulators had become "very sloppy" on bank reserve requirements against liabilities, says Frank Genovese, an economics professor emeritus of Babson College in Wellesley, Mass. He suggests that judges charge financial institutions large fees to foreclose on a property. That move would encourage banks to work out better mortgage deals with homeowners. If not, it would provide municipalities with extra revenues.

Many economists worry that further financial troubles ahead could arise from home equity loan defaults, a multiplication of commercial bank failures, a huge price slump in commodities, or more fancy financial derivative failures.

If such further troubles do arise, the institutions will still likely seek government help. As a new saying in the financial community goes: "Just as there are no atheists in foxholes, there are no libertarians in a market collapse."